oGK_IV( ) Example - Equity Put Option

Description

Consider a European option to sell GBP / buy USD. The current exchange rate is 1.45 USD per GBP. The 'domestic' risk-free rate in the United States is 6% while the 'foreign' risk-free rate in Great Britain is 7% (both expressed on an actual/365 basis). The option has a strike rate of 1.40 USD per GBP, matures on 1 December 2002, and has a market value of $0.0310 USD per GBP. What is the implied volatility as at 1 April 2002?

Function Specification

=oGK_IV(2, 0.031, "1/4/02", "1/12/02", 1.45, 1.4, 0.06, 0.07)

Solution

This option is treated as a put on the GBP. This option is treated as a call on the USD. As there is no closed form solution for implied volatility, the Newton-Raphson iteration procedure is used to solve for volatility.

When calculating implied volatilities, the Newton-Raphson iteration procedure uses the Manaster and Koehler seed value as the initial estimate of the volatility. This is calculated as follows (see below for r and T parameter values):

The procedure will iterate using more and more precise estimates of volatility until the difference between the option value derived from the volatility estimate and the given market option value is less than the desired accuracy level (see Newton-Raphson). In this example the desired accuracy level is 11 decimal places.

The continuous equivalent of the actual/365 risk-free interest rates are calculated as follows:

Since $0.18935 is above the market value of the option, $0.0310, the volatility of 47.07% is too high. The oGK( ) value is therefore computed at a lower volatility, i.e., x1 < x0. Referring to the Newton-Raphson iteration procedure, x1 is determined as:

Using the same parameter values as above with a new volatility estimate of 10.76%, the oGK( ) equation returns $0.0308. As this value is below the market value of the option the next volatility trial is:

This process continues until the convergence criteria is met, which for this example occurs on the 4th iteration at a volatility of 10.8077%.